International asset allocations and capital flows: the benchmark effect

As financial intermediaries tracking benchmarks grow in importance around the world, the issue of which countries belong to relevant international benchmark indexes (such as the MSCI Emerging Markets) has generated significant attention in the financial world (Financial Times, 2015). The reason is that the inclusion/exclusion of countries from widely followed benchmarks has implications for the allocation of capital across countries.

As institutional investors become more passive, they follow benchmark indexes more closely. These benchmark indexes change over time, as index providers reclassify countries, implying that investment funds have to re-allocate their portfolio among the countries they target. The capital flows generated by these portfolio re-allocations are important because worldwide open-end funds that follow a few well-known stock and bond market indexes manage around 37 trillion U.S. dollars in assets (ICI, 2016).

As we document in a recent study (Raddatz, Schmukler, and Williams, 2017), these changes in benchmark indexes can produce unexpected effects in international capital flows, caused by portfolio reallocations of both passive and active institutional investors. These changes are not necessarily related to economic fundamentals, and affect asset prices as benchmark changes are implemented.

One clear example of these counterintuitive reallocations happened when MCSI announced in 2009 that it would upgrade Israel from emerging to developed market status, moving it from the MSCI Emerging Markets (EM) Index to the World Index. When the upgrade became effective in May 2010, Israel faced equity capital outflows of around 2 billion dollars despite its better status. The reason is that Israel became a smaller fish in a bigger pond. Israel’s weight in the MSCI EM Index decreased from 3.17 to 0, while it increased from 0 to 0.37 in the MSCI World Index. Israeli stocks in the MSCI index fell almost 4 percent in the week of the announcement and significantly underperformed the stocks not included in the index. The week prior to the effective date (when index funds rebalanced their portfolio) there was a 4.2 percent drop in the MSCI Israel Index, versus a 1.5 fall in the Israeli stocks outside the index.

The effects of index reclassifications go beyond the countries and asset classes being specifically targeted. Spillovers could occur to other countries that share a certain benchmark with countries affected by reclassifications. A clear example of this is the upgrade in June 2013 of Qatar and United Arab Emirates (UAE) from the MSCI Frontier Markets (FM) Index to the MSCI EM Index. Together, these two countries were around 40 percent of the MSCI FM Index before the reclassification. When this reclassification took place, funds tracking closely the MSCI FM Index had to sell securities from these two countries and use the money to invest in the rest of the countries in the MSCI FM Index. This resulted in significant capital inflows and stock market price increases in countries such as Nigeria, Kuwait, and Pakistan.

These movements in financial markets have led to speculations and market movements related to potential new reclassifications. One recent and prominent example is that of China. For the past two years, MSCI delayed numerous times the introduction of China A-shares as a part of the MSCI Emerging Markets. Finally, in June 2017, it confirmed the inclusion of only a fraction of these stocks, creating capital inflows into the Chinese stock markets, and increases in stock prices (Financial Times, 2017). Chinese sovereign bonds may see similar capital inflows if J.P. Morgan, Citibank, and Barclays decide to add China into their flagship bond indexes (CNBC, 2017).

Academics, financial institutions, and policy makers have already started paying attention to the potential effects of benchmarks on capital flows and asset prices, as well as on herding, momentum, and risk taking (BIS, 2014; Arslanalp and Tsuda, 2015; IMF, 2015, Shek, Shim, and Shin, 2015; Vayanos and Woolley, 2016). More work in this area would be welcomed as passive investing continues expanding.